How To Avoid The Worst Style ETFs

Picking from the multitude of style ETFs is a daunting task. There are as many as 40 in any given style and at least 217 ETFs across all styles.

Why are there so many ETFs? The answer is: because ETF providers are making lots of money selling them. The number of ETFs has little to do with serving investors' best interests. Below are three red flags investors can use to avoid the worst ETFs:

How To Avoid ETFs with Inadequate Liquidity

This is the easiest issue to avoid and my advice is simple. Avoid all ETFs with less than $100 million in assets.

How To Avoid High Fees

ETFs should be cheap, but not all of them are. The first step here is to measure what is cheap and expensive.

To ensure you are paying at or below average fees, invest only in ETFs with an expense ratio below 0.45%, which is the average total annual cost((TAC]) of the 217 US equity style ETFs I cover. Weighting by assets under management, the average expense ratio is lower at 0.19%. A lower weighted average is a good sign that investors are putting money in the cheaper ETFs.

Figure 1 shows the most and least expensive style ETFs in the US equity universe based on total annual costs. ProShares provides three of the five most expensive style ETFs. ProShares provides all five of the most expensive sector ETFs. More on sector ETF costs is here.

Figure 1: Most And Least Expensive ETFs (as of 12/18/2012)

Sources:New Constructs, LLC and company filings

AdvisorShares Madrona Forward Domestic ETF (NYSEARCA:FWDD) and AdvisorShares TrimTabs Float Shrink ETF (NYSEARCA:TTFS) are the two most expensive US equity style ETFs I cover. Schwab U.S. Broad Market ETF (NYSEARCA:SCHB) is the least expensive. Vanguard Total Stock Market ETF (NYSEARCA:VTI) ranks well also and it has over $24 billion in assets. Ironically, ProShares' Ultra Russell2000 (NYSEARCA:UWM), UltraPro Russell2000 (NYSEARCA:URTY) and Ultra Russell2000 Growth (UKK) are the best-rated ETFs in Figure 1 even though they are among the most expensive. All of the cheapest ETFs do no better than a neutral or 3-star rating. UWM, URTY and UKK earn good ratings because the quality of their holdings is strong enough to justify a higher cost. On the other hand, the cheaper ETFs hold poorer stocks. And no matter how cheap an ETF, if it holds bad stocks, its performance will be bad.

This result highlights why investors should not choose ETFs based only on price. The quality of holdings matters more than price.

How To Avoid ETFs With the Worst Holdings

This step is by far the hardest, but it is also the most important because an ETF's performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each style with the worst holdings or portfolio management ratings. The styles are listed in descending order by overall rating as detailed in my 4Q Style Rankings report.

Figure 2: Style ETFs With Worst Holdings (as of 12/18/12)

Sources: New Constructs, LLC and company filings

My overall ratings on ETFs are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence done on each stock we cover.

Do Not Trust ETF Labels

Many ETFs are labeled "index" ETFs. Naturally, many investors might assume that having "index" in the ETF's name means all the holdings are the same or the provider cannot influence the nature of the holdings, but that is not true.

For example, of the three "index" ETFs in the mid-cap growth style, two get a neutral rating while one gets a Dangerous rating. How is that possible if they are supposed to hold the same stocks? The answer is that they do not hold the same stocks.

There is no overlap in the top 5 holdings among these three ETFs. Their portfolios are not close to being the same. And three is a meaningful difference in the quality of holdings.

The point is that investors cannot trust the "index" label to mean that all the ETFs or mutual funds with that label hold a standard portfolio of stocks.

The Danger Within

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron's says, investors should know the Danger Within. Put another way, research on ETF holdings is necessary due diligence because an ETF's performance is only as good as its holdings' performance.

PERFORMANCE OF ETF's HOLDINGs = PERFORMANCE OF ETF

Note that no ETFs with a dangerous portfolio management rating earn an overall rating better than two stars. These scores are consistent with my belief that the quality of an ETF is more about its holdings than its costs. If the ETF's holdings are dangerous, then the overall rating cannot be better than dangerous because one cannot expect the performance of the ETF to be any better than the performance of its holdings.

Best And Worst Stocks In These ETFs

US Steel (NYSE:X) is one of my least favorite stocks held by SPHB. As detailed in Sell U.S. Steel Before Pensions Sink the Stock, this stock could see significant downward pressure as more investors become aware of the $5.2 billion in liabilities related to its "Pension Benefits," "Other Benefits" and "Other postemployment benefits" plans. A loophole in GAAP accounting minimizes, at least temporarily, the impact of big pension liabilities on reported earnings. Specifically, US Steel boosted its 2011 earnings by increasing its expected return on plan assets ("EROPA") assumption for its pensions to 7.79%[1], up from 7.75% in 2010. Page F-40 in US Steel's 2011 10-K filing has the details. For those that say all of this information is already baked into the stock price, I suggest you look again. According to my discounted cash flow model, to justify the stock valuation at $25.71/share, the company has to grow its after-tax cash flow (NOPAT) by 5% compounded annually for nearly 15 years. That is a rather high growth rate for a long time for a commodity business.

Oracle Corporation (NYSE:ORCL) is one of my favorite stocks held by IWF. ORCL is a leading provider of database products and services. Despite being the leader in an industry on which our data-centric world depends, ORCL's stock (at ~$34.50/share) has a Price-to-Economic Book Value of .98, which means the market expects its after-tax profits (NOPAT) to permanently decline by 2%. This pessimistic valuation is surprising given that ORCL has had positive economic earnings every year since 1998 and has grown them at an annual CAGR of 21%. It is not often that an industry leader that creates value for shareholders year-after-year is sold at a discount. ORCL earns my Very Attractive rating.

Disclosure: I own ORCL. I receive no compensation to write about any specific stock, sector or theme.

Disclosure: I am long ORCL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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